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Will the Fed Hurt the Dow's Dividend Giants?

The Dow Jones Industrials (DJINDICES: ^DJI) had lost a modest 34 points as of 12:30 p.m. EDT Wednesday. Many investors are waiting on the Federal Reserve's next pronouncement regarding its direction for monetary policy, which is due at 2 p.m. EDT. There have been more discussions lately about the need for higher interest rates at some point in the future. One fear that investors in the Dow Jones Industrials need to consider is whether a change in Fed policy could eventually hurt the index's dividend stocks, with a particular emphasis on high-yielding telecom giants AT&T (NYSE: T) and Verizon (NYSE: VZ) .

Why Dow dividends got so popularThe Dow has always been a hot spot for dividend stocks, and all 30 of the average's components today make at least modest dividend payments to shareholders. The well-known, solid businesses that make up the Dow are particularly conducive to having strong dividends, as mature companies have often already made the most of their growth opportunities and therefore have more free cash flow to return to shareholders through payouts and stock buybacks.

For those seeking income, though, alternatives to the stock market have become a lot less attractive since the Fed cut interest rates to the bone in advance of the financial crisis. Savings accounts and bank CDs pay a tiny fraction of what they did before the crisis, giving those who rely on their portfolios almost no income. Even a 10-year Treasury bond yielding 2.5% gives income investors absolutely no potential for growth and no regular increase in interest payments throughout its term. By contrast, AT&T and Verizon have dividend yields well above what Treasuries currently pay, and shareholders can expect growth in the future as their respective wireless network businesses continue to prosper.

Can the Fed reverse course?The resulting shift among income investors from Treasuries to the Dow Jones Industrials and other dividend-rich pockets of the stock market makes perfect sense. But if the Fed moves too aggressively to raise rates, the opposite effect could occur and wreak havoc on top yielders AT&T and Verizon, as well as other dividend stocks in the Dow.

For instance, before the Fed started cutting interest rates prior to the financial crisis, short-term rates were above 5%. That gave income investors a chance to earn 5% or more on savings accounts, bank CDs, and other investments that were protected from the risk of loss of principal. If interest rates return to the 5% range, then more nervous investors who might never have truly wanted to invest in the Dow in the first place could go back to fixed-income investments. That could hurt AT&T and Verizon, as the Dow's highest-yielding stocks, from a shareholder supply and demand perspective even if their respective growth prospects remain intact -- investors would want a dividend-yield premium to prevailing interest rates to compensate them for stock market risk.

The Federal Reserve needs to be extremely careful in its exit strategy on interest rates. Even though the Dow Jones Industrials have soared to record levels recently, the potential for financial-market fallout from unexpected fluctuations in interest rates could reverse those gains in a hurry.

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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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